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Flow of Funds Washes Out Pessimists

Marc Chandler

The U.S. reported third-quarter flow of funds Dec. 7. There are several points in the report that illustrate larger developments, but the key takeaway is that contrary to the take from the doom-and-gloom camp (one member, the economics editor of the Financial Times, sees the U.S. as being "comfortably on the road to ruin"), American prosperity continues unabated.

First, the flow of funds report shows that household net wealth in the U.S. rose by about $800 billion in the third quarter. To put this in perspective, it's roughly Canada's GDP; that is, U.S. household net worth increased by about the value of all the goods and services the Canadian economy produces in a year.

This is not a poke at Canada, a G7 economy. It's a way to point out that despite falling house prices and the current account deficit, which some pundits say is making the U.S. poorer, household net worth in the U.S. has never been higher.

This is also a timely reminder that stock terms, such as "household net worth," may be more important than flow terms. For example, even as the current account deficit is rising as a percentage of GDP, what is viewed from a stock perspective as a "net international investment position" has fallen in recent years as a percentage of GDP -- though there has been deterioration in Europe, and especially the U.K. Preliminary figures seem to suggest that the U.S. net international investment position is likely to have fallen this year as a fraction of GDP.

Another important takeaway from the flow of funds report is the still-unsated foreign appetite for U.S. securities. In dollar terms, foreign investors increased their debt holdings by $190.3 billion and equity holdings by $115.9 billion in the third quarter.

Of course, some will argue that when the U.S. current account deficit is increasing, foreigners by definition will buy more U.S. assets. However, the $300 billion foreigners bought in the third quarter is much larger than the U.S. current account deficit, and the prices foreigners paid do not appear lower but rather higher because the U.S. equity and bond markets advanced. The dollar was only slightly weaker in the third quarter. Last year, foreign investors bought $1.21 trillion of U.S. assets; the pace in the third quarter was similar.

This does not mean that the dollar is a buy; rather, it suggests that at least through the third quarter, there was no sign of a dollar crisis. The greenback has sold off at the end of the last couple of years only to bounce back early in the new year.

Could the greenback repeat 2005 in 2007, when after selling off hard at the end of 2004, it trended higher for most of 2005? Maybe, especially if the Federal Reserve, the stock market, commodity markets and emerging markets are right and the U.S. has a soft landing. I will be looking for signs that the U.S. economy is going to accelerate again by spring 2007.

But the hard-landing camp has been in no way humbled by the November jobs data, which appear to be fairly constructive. The hard-landing camp pins its arguments on U.S. housing market weakness crippling the consumer and dragging the economy down. Last summer, several big-name economists warned that the U.S. was already on the leading edge of a recession. The labor market is no tighter now than it was in September or October, and the tightness in those months didn't dissuade the pessimists.

What will it take to convince the doom-and-gloom camp to change its view? Surely the official data showing that household net worth is at record levels won't sway these pessimists. Surely the fact that personal income in the U.S. rose 5.8% above year-ago levels, well above the rate of inflation, won't, either.

Unfortunately, from where I sit, there seems to be very little that would convince those unhappy campers the U.S. is having a soft landing until the U.S. reports or is anticipated to report a 3-handle on its GDP.

Although it's fashionable to argue that the U.S. is slowing down and Japan and Europe are picking up the slack, I wonder if just the opposite is true. Europe faces a triple threat next year in the form of higher interest rates, higher taxes and a strong euro. Structural reforms have been limited in most eurozone countries. Growth probably has already peaked in the cycle. Japan's economic recovery is the longest since WWII but is showing its age.

Ironically, as the doom-and-gloom camp took control of the foreign exchange and debt market, the U.S. economy grew more than twice as fast as the Japanese economy and slightly faster than the eurozone's economy. Now that's what I'm talking about.